Finance leasing explained – what is it?

Most businesses need expensive assets to produce the goods and services they sell. These assets are typically cars, vans, plant and machinery. Without them, many businesses simply cannot function. However, buying big-ticket items can create problems with cashflow and for companies with seasonal finances, spending a large sum all at once may be impossible. But not to worry. Say hello to the finance lease – the low-cost way for businesses to secure the major tools they need.

Buy over time with a low deposit. Roll maintenance and repairs into the deal. Reclaim tax and VAT. Finance leasing is fast, flexible and affordable. Give your business what it requires without creating a financial crunch.

The term ‘finance lease’ has become a catchall phrase for asset financing that is not a dedicated purchase agreement (such as hire purchase). In fact, there are three main types of finance lease:

• Finance lease: 

A finance lease allows your business to use an asset for a fixed period and for a fixed monthly rental cost. At the end of the agreement the business will have the option to purchase the asset for a pre-agreed sum. A finance lease allows businesses to spread the cost of the asset over time and with lower monthly payments than if they were to purchase the asset. In many cases, (except company cars), businesses may reclaim 100% of the VAT element of the monthly cost – including any maintenance charges.

• Operating lease:

Similar to finance leasing, but the lessee (you), cannot purchase the asset at the of the contract. Additionally, the agreement will include a Residual Value that is based on the period of the lease and the estimated value of the asset at the end of the contract.

At the end of the agreement the asset is sold to a third party on behalf of the finance company. If the asset sells for more than the Residual Value, the finance company will refund a percentage of the surplus back to you. If the asset sells for less than the Residual Value, you will be liable to make a further payment to the finance company.

An operating lease allows businesses to use the asset for a lower monthly cost than finance leasing or buying an asset with hire purchase. Depending on the asset being leased, operating leases may come with included maintenance and repairs. In many cases, (except company cars), businesses may reclaim 100% of the VAT element of the monthly cost – including any maintenance charges.

• Contract hire:

The simplest form of lease. Contract hire is just a long-term rental. The business rents the asset for a fixed term – typically 2-3 years – and pays a fixed monthly sum for its use. Maintenance and repairs are usually included in the deal. At the end of the contract, the business hands the asset back to the lessor. There is no Residual Value to meet, and no option to buy the asset. In many cases, (except company cars), businesses may reclaim 100% of the VAT element of the monthly cost – including any maintenance charges.

Finance leasing for a company car works as above, with the agreement often including maintenance and repairs and a mileage cap. Lessees who exceed the mileage cap will pay extra for every mile they go over the limit. Depending on the type of finance lease, the lessee may have the option to buy the at the end of the contract period.

Company cars are taxed differently from most business assets. Even though the vehicle has been leased by a business (which may be a limited company, PLC, partnership, or sole trader), the organisation may only claim back some of the lease cost – which will depend on the ratio of business to personal use of the car. Additionally, in most cases, businesses may only be able to reclaim up to 50% of the VAT element of the monthly cost. This will reflect any personal use of the car. 

Finance leases allow businesses to spread the cost of using the car over time and at a lower monthly cost than if they were to purchase the car with a hire purchase agreement. In most cases, the initial deposit is equal to one month’s lease payment.

ABC Plumbers need a new van for their business. Instead of paying cash or opting for a hire-purchase agreement that comes with higher monthly payments, they choose to lease a new vehicle. The deal they select is an operating lease. It works like this:

• The van costs £20,000. 
• The lessor (lender) offers to lease the van to ABC (the lessee) for £350 per month, including service costs, and for 48 months. The Residual Value is set at £4,000. 
• ABC pays one month deposit of £350 and drive their new vehicle away. Over 4 years, they pay a total of £16,800 for use of the van. 
• At the end of the contract, the vehicle is sold for £5,500 – £1,500 more than the agreed Residual Value. The lessor passes 95% of £1,500 back to ABC. They receive £1,425 which they use to lease a new vehicle and put the surplus cash back into their business.

The five criteria of a finance  lease (not an operating lease or contract hire agreement) are:

1. Lessee may own the asset at the end of the lease.
2. The lease contains a ‘bargain purchase’ option – this means the lessee may buy the asset for less than the market value. 
3. The lease is active for a major part of the asset’s economic life.
4. The total of the lease payments will represent most of the fair value of the asset when the lease was taken out.
5. The asset is of such a specialised nature that it will have no further value to the lessor at the end of the contract period.

If your lease contains one or more of the above, you have chosen a finance lease.

IFRS 16 is a UK accounting rule designed to report information that faithfully represents lease transactions and provides a basis for users of financial statements to assess the amount, timing and uncertainty of cash flows arising from leases. To meet that objective, a lessee should recognise assets and liabilities arising from a lease as follows:

• Record the present value of all lease payments as the cost of the lease.
• Record the interest portion of each payment as an expense.
• Depreciate the cost of the asset over its applicable write-down period.
• Recognise the disposal of the asset at its retirement.

Depending on the type of asset being leased (car, van, machinery, etc), the lessor may be able to claim up to 100% of the value of the lease payments as a tax deduction.